The country’s financial system is still not easy to access; money has trickled rather than flooded into its stock exchange since January’s deal with the US to lift sanctions. Nevertheless, as the country emerges from years of isolation, important changes are taking place that could herald a new era for Iran’s capital markets.

Attracting investors to the Iranian capital markets has long been a challenge. International investors have been scared off by sanctions and the reputational risk of doing business in Iran; even their domestic counterparts have found it more profitable to keep their money in banks than in the more volatile stock market. Yet the outlook is changing for both groups. Could the Tehran Stock Exchange be on the cusp of a breakthrough?

The appeal for many investors of the TSE and the junior Farabourse market is largely tied to the difference between bank deposit rates and the returns they can expect from investments in listed companies. That gap has been narrowing, most recently in June when the Central Bank of Iran cut the one-year deposit rate from 18% to 15%, still an astronomical level for most markets.

Turquoise Partners, a Tehran-based investment firm, noted hopefully in a recent market review issued “with dividend yields on the market at 12%, not far below deposit rates of 15%, things are edging ever closer to a tipping point where the stock market becomes the most attractive asset class.”

For foreign investors, the big change was the Joint Comprehensive Plan of Action (JCPOA) in January to lift most sanctions, in return for Tehran scaling back its nuclear programme. Since then, investors have been keen to unearth opportunities to justify the hype. Invariably, those coming to Iran find the puzzle that is more complex than they might like, but the pieces are gradually falling into place.

“We are seeing signs of increased activity, both in terms of FDI [foreign direct investment] and foreign portfolio investment,” Ramin Rabii, chief executive of Iran-focused Turquoise Partners, said on a call with investors in mid-June. “Having said that, the ease of doing business is far from perfect. There are a lot of challenges. The main one is the issue of the banking route and banking transfers, which has remained a main obstacle for transfer of funds back and forth.”

Just how difficult it has been to move money into the country (or indeed out again) is obvious from a story dating back to January, when the US government put $400 million worth of cash, made up of Swiss francs, euros and other currencies, onto a cargo plane and flew it to Tehran. This was part of a larger debt the US has owed Iran for decades, after a deal to sell military equipment was cancelled in the wake of the 1979 revolution. It was a rather novel way of getting around the lack of formal banking channels between the US and Iran; it also highlighted that doing business with Iran sometimes requires a flexible approach.

A number of smaller European banks are now said to be processing transactions with Iran, along with others in Malaysia and the UAE. The Iranian authorities have also been trying to forge new banking ties with other countries. For example, in August, the central bank signed a memorandum of understanding with its counterpart in Azerbaijan to set up correspondent relationships between banks in the two countries.

A second sticking point has been the relatively high cost of bank transfers, but this is also set to change. Until recently, bank transfers had to be based on the official exchange rate, which in early August was running at IR30,900 to the dollar, around 14% more expensive than the market rate of IR35,344. However, in late July the central bank said it would allow banks to offer the market rate on foreign exchange transactions, which should mean that more investment will flow into the country through the banks.

“This is very significant, as it should allow large FDI to come into Iran more easily,” says Kiyan Zandiyeh, portfolio manager for London-based Sturgeon Capital, which operates an equity fund investing in listed Iranian companies.

In the medium term, the central bank has vowed to close the gap between the two rates and end the system of parallel exchange rates, either later in 2016, or at least by the end of the current Iranian year, which falls in March 2017.

The cost and complexity of bank transfers has not put off all investors. German industrial conglomerate Henkel, which has been active in Iran since the early 1970s, increased its stake in local detergent manufacturer Henkel Pakvash, which is listed on the Farabourse, from 60% to 90% in May. Wulf Klüppelholz, a spokesman for Henkel, confirmed the deal but declined to give any further details.

However, Afsaneh Orouji, director of inspection and audit at the Farabourse, said in a statement issued a few days after it was completed that the deal for €51 million was approved by the Securities and Exchange Organization and that “the amount was calculated in the currency exchange rate set by Iran’s Central Bank rather than [the] free market rate in the country”.

Exchange houses

Instead of using banks, other investors have preferred to transfer money into Iran via exchange houses – credit institutions regulated by the central bank that can facilitate cross-border money transfers.

Before the recent change in rules for banks, the exchange houses had the key advantage that their transactions were based on the cheaper market rate for the Iranian rial. Several of the international funds investing in the country’s stock market have used them, including Sturgeon Capital and Charlemagne Capital, which is also based in London. Now that banks are also able to offer the market rate, the exchange houses are likely to lose out on some or all of this business.

To date the amount of money that has come into the market has been limited, even if the number of potential investors continues to rise. According to the Central Securities Depository of Iran, stock market trading licences have been given to 636 foreign investors to date, including 25 in July alone. The investors come from 31 countries, ranging across Asia, the Middle East, Africa and Europe, as well as the US, despite some sanctions remaining in place.

Such licences are necessary to buy and sell shares. However, given the amount of money that has actually been invested, it appears that many are setting up, but not yet making meaningful investments in shares, with the bulk of the money ending up in bonds. Ali Naghavi, chairman of the Iran Financial Centre, says around $500 million has been invested in the Iranian capital market since January.

But Zandiyeh says, excluding the Henkel deal, overseas investors have put just $22 million into listed Iranian companies so far this year. On an exchange with a total market capitalization of more than $90 billion, that is a very small drop. Zandiyeh says, the numbers suggest “there’s a lot of money waiting on the sidelines”.

Sturgeon Capital launched its Cayman Island-domiciled Iran fund in December 2015 and has just under $10 million in assets under management with stakes in 20 listed companies across the TSE and Farabourse, as well as in three bond issues.

The UK’s Charlemagne Capital is running another fund in partnership with Turquoise Partners. Turquoise set up the Cyprus-domiciled fund in 2006 and Charlemagne came on board in December last year. At roughly €65 million, it is the largest active fund investing exclusively in Iranian securities, according to Dominic Bokor-Ingram, fund manager at Charlemagne.

Both Sturgeon and Charlemagne say their equity funds have made good gains so far this year. Zandiyeh says Sturgeon’s fund is up more than 14% in euro terms since it started investing in February, while Bokor-Ingram says that as of June the Charlemagne-Turquoise fund was up by 26% from the start of the year.

Another new entrant is the Griffon Iran Flagship Fund, launched by Tehran-based Griffon Capital earlier this year. The fund is also domiciled in the Cayman Islands.

Alongside these, there has also been a small but noteworthy trend for new private equity funds. Griffon already runs one such fund, while Turquoise is setting up a venture capital fund, in partnership with Swiss firm Reyl & Cie. The Iranian firm says it will focus on local consumer goods, pharmaceuticals and hospitality companies and is aiming to raise $200 million this year. It’s also looking at establishing a fixed-income fund for the Iran market.

Another, indirect route for investors wanting exposure to Iran’s stock market should emerge in the coming months, when Swedish investment house Pomegranate lists its shares on the Stockholm Stock Exchange, which it plans to do before May 2017. Pomegranate focuses on investments in unlisted consumer technology companies in Iran, such as car-sharing start-up Carvanro and online classifieds platform Sheypoor. However, it also has a 15.2% stake in Griffon Capital, which it valued at €2.8 million in its 2015 annual report.

In May this year, Pomegranate raised €60 million in what it described as a pre-IPO placing. The investors were mainly from Europe. That fits in with a larger pattern of corporate investment in Iran in the months since the JCPOA came into force.

However, some investment executives say they are seeing most interest from the US. While US citizens are barred from dealing with Iran due to the continuing sanctions programme, there are efforts afoot to explore any legal loopholes that could bypass these provisions. Some doubt that such an option will be possible for some time and the Office of Foreign Assets Control (OFAC), the arm of the US Treasury that deals with sanctions, is likely to keep a close eye on anyone who tries.

Ali Nassersaeid, co-founder of the American-Iranian Business Council, says the chances of US investors being able to access the TSE are “pretty much slim to none, at least for the next couple of years. There are ways to structure an entity outside the US to conduct transactions. However, the entity cannot include a US person in a controlling capacity. The only safe way to proceed with such a plan involving a US person would be to apply to OFAC for a licence.”

Volatility

For those who are willing and able to get involved, there are some decent gains to be made, although there are many risks too. The Tedpix, the TSE’s main index, has more than tripled in value over the past four years, rising from around 24,000 points in August 2012 to more than 78,000 points by August this year. In comparison, the MSCI Emerging Markets index has lost 8% of its value over that time, while the MSCI Frontier 100 Index rose by 26.5%.

Of course a stock market would not be a stock market without volatility, and there has been plenty of that too. The Tedpix was on a bull run from late 2012 until it peaked at 89,500 points on January 5, 2014. Some of those gains drifted away over the course of the next two years, but the market has rebounded strongly this year. The index shot up in January, around the time the sanctions deal was confirmed. It continued to rise in February and March. Thereafter some ground was lost, with a 9% fall in the second quarter of the year, followed by a rebound in July and August. Even with that second quarter slump, the market was up 26% since the turn of the year.

This year’s movements reflect two big (and opposing) trends: enthusiasm for companies’ prospects in a post-sanctions era, mixed with realism about the difficulty in attracting capital from overseas. For investors this means that stocks have to be chosen with care. Sentiment and rumour play a big part in the trajectory of stocks on the TSE, not least because retail investors account for around half of the trading volumes, but also because reliable information is often a scarce commodity.

“The crucial part of the process is to ensure that buy/sell decisions are based on accurate information,” says Nassersaeid. “The TSE and its regulatory branches are still working through their processes to ensure accurate, timely and transparent information is released.”

Unsurprisingly, views differ widely as to what sectors offer the best opportunity in such a market. Naghavi points to petrochemicals, insurance, power and industries related to oil and gas as attractive options. Nassersaeid suggests the two most promising sectors for the longer term are petrochemicals and raw materials firms producing copper, iron ore and the like. He is warier about other areas such as construction, banking, insurance and IT until economic conditions improve.

There is certainly the potential for the Iranian economy to grow quickly, but its short-term fortunes rely on domestic and international political issues, which are hard to predict. For one thing, the outcome of Iran’s presidential elections in May 2017 will set the template for the country’s relations with the outside world for years to come. Even so, some appear optimistic.

“Our thesis for Iran is the same as in any frontier market that’s coming out of one political or economic system and going into another,” says Bokor-Ingram. “Political reform leads to economic growth and we want to be exposed to sectors and companies that can take advantage of that economic growth. We forecast that the Iranian economy, if things progress as they should do, can grow by 6% to 8% a year for the next 10 years. There’s certainly the spare capacity in the economy for that to happen, and we want to be in companies that can take advantage of that growth.”

Others predict slower growth rates for the near term, with the IMF suggesting GDP will expand by 3.7% to 4.5% between now and 2021. However, there are a few reasons why some companies should grow quickly in the coming years, even if the economy as a whole does not match the highest hopes.

For one thing, many Iranian businesses have been operating below capacity during the sanctions years and, with the shackles now removed, they should be able to expand their output even without much investment. For companies that were more productive, expansion plans that had been put on hold can start to move forward. Turquoise predicts that listed companies will post earnings growth of around 10% on average over the year to March 2017.

The biggest boost of all could come from Iran’s inclusion in international indices, such as those run by MSCI. Zandiyeh says that, based on the size of the TSE, it “should conservatively occupy between 25% and 30% of the MSCI Frontier Index. Looking at the money which tracks the index, up to $7 billion to $10 billion would have to enter the market. That could happen in the next year or two.”

Set against all that, there are some reasons for caution, not least the risk of ending up with a stake in a company run by the Islamic Revolutionary Guards Corp (IRGC), which remains a firm target of US sanctions. IRGC’s principle holding in a publicly listed company is in Telecommunication Company of Iran (TCI), the monopoly fixed-line telecoms provider. The IRGC owns 50% of TCI via its Etemad-e Mobin affiliate. TCI in turn owns 90% of Iran’s largest mobile operator, Mobile Telecommunication Company of Iran (MCI), which has its own stock market listing. Both TCI and MCI are among the top five companies on the Iranian bourse, with market values of $4.2 billion and $4.1 billion respectively at the end of June.

There have been suggestions that the IRGC could sell its stakes in these firms. The IRGC did offload its interest in carmaker Bahman Group in June, with local media reporting that Visman Motor has become the majority shareholder.

“The removal of sanctions has opened up the available pool of companies that Sturgeon Capital can invest in,” says Zandiyeh. “Of the 600 or so stocks across the TSE and the Farabourse, all but 50 were off-limits while sanctions were in place. Now the investment universe has expanded to include almost the entire stock market, with the only exceptions being companies controlled by the Revolutionary Guards.”

Further concerns

Beyond the problems of scarce banking links, parallel exchange rates and IRGC involvement, there are further concerns for investors, as a consequence of the relatively immature nature of the market and because it has been separated from the international mainstream for so many years.

Local regulations stipulate that stocks cannot be held by a global custodian, but instead must be held by the Central Securities Depository of Iran (CSDI). That will be a stumbling block for those leading institutional investors that prefer to use custodians. The authorities have tried to address this problem, with Mohammad Sajjad Siahkarzadeh, international affairs director at the CSDI, telling the Securities & Exchange News Agency in August that there are numerous other ways to invest in the market without using a global custodian.

“There are at least six ways for foreign investors to get into the Iranian market,” he said, although the report then somewhat confusingly included the option of using global custodians to help with investment as one of the six.

Furthermore, there are no credit ratings agencies working in Iran, nor a culture of analyst reports and coverage. Financial reports and other data are often only available in Farsi, and global accounting norms, such as international financial accounting standards are only starting to be introduced. All this makes it harder to evaluate companies for investment. Instead, investors will have to rely on the forward guidance that companies issue and their own research into a company’s performance and prospects.

Some of these concerns are being addressed and there have been signs that the market is moving to become more professional, with a wider range of tools on offer to investors. For example, Pouya Finance, a subsidiary of Mofid Securities, the largest broker in Iran, recently launched BourseView, an online tool providing real-time and historic information about TSE and Farabourse stocks. One investor describes this as “the Bloomberg of Iran”. In addition, the Securities and Exchange Organization (SEO) has invited credit ratings agencies to apply for licences.

The regulatory structure is also undergoing change, with Shapour Mohammadi appointed as the new chairman of the SEO in July, taking over from Mohammad Fetanat, who resigned and has been appointed as an adviser to Ali Tayebnia, minister of economic affairs and finance. Mohammadi subsequently outlined some of his priorities in a speech, including a promise to push for the introduction of derivatives trading, short-selling and buying stocks on credit.

Macroeconomic trends in Iran ought to drive more investors towards the market too, helping improve liquidity levels, which are another concern, particularly for many of the smaller stocks.

As well as bank interest rates dropping from 18% to 15%, interest rates on loans came down from 22% to 18% in June and the inflation rate has also been steadily falling since president Hassan Rouhani came to power in August 2013. Three years ago, inflation was running at close to 40%, by this summer it had dropped below 10%.

Bonds are underwritten by the banks in Iran, carry high fixed interest rates for multiple years and can always be redeemed for at least their par value. That means investors can lock in high double-digit returns for several years.

Clemente Cappello, chief investment officer of Sturgeon Capital, says: “Nearly $10 trillion in global bonds trade at negative yields, whereas in Iran the yields are 18% to 20%. GDP is rising, and the population is young – 60% are under the age of 30 – while it is ageing in the west. It makes for an interesting situation for investment.”

The question is how quickly will international investors be willing, able or brave enough to take advantage of those trends?